Investment Analysis & Portfolio Management

UNIT ONE
AN OVERVIEW OF INVESTMENT
What is an investment?
In finance, an investment is a monetary asset purchased with the idea that the asset will provide income
in the future or appreciate and be sold at a higher price. In other word, an investment is the commitment
of money or capital to purchase financial instrument or other assets in order to gain profitable return in
form of interest, income, or appreciation of the value of the instrument. In financial sense investment
include the purchase of bonds, stocks, short-term financial assets or real estate property. Beside to these,
in economics discipline an investment is defined as the purchase of goods that are not consumed today
but used in the future to create wealth.

In general, an investment is the current commitment of money or other resources in the expectation of
obtaining future benefits. For example, an individual might purchase shares anticipating that the future
proceeds from the shares will justify both the time that his/her money is tied up as well as the risk of the
investment.

Investment vs. Speculation

There is often some confusion between the terms investment, speculation and gambling. This confusion is often
linked with investment made in the stock market.

John Maynard Keynes, described investment as “the activity of forecasting the prospective yield of assets over
their life time”. In contrast, speculation means “the activity of forecasting the psychology of the market”.
Speculation has come to mean different things to different people. However, its original meaning is to reflect or
speculate without a factual basis.

A speculator can be defined as someone that seeks to buy and sell in order to take advantage of market price
fluctuations. An investor is someone who holds on the securities that provide a good income or capital gain by
virtue of them being based on something of real and increasing value.

The most realistic distinction between the investor and the speculator is found in their attitude toward market
movements. The speculator's primary interest lies in anticipating and profiting from market fluctuations. The
investor's primary interest lies in acquiring and holding suitable securities at suitable prices.

Investment vs. Gambling

Many beginner investors often confused about the differences between investing and gambling.
 Gambling is defined as, an act putting money at risk by betting on an uncertain outcome with the hope
that you might win money. In other word, gambling is an act of taking the risk of losing money in the
expectation of a desired result.

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 Investing means committing money in order to earn a financial return.

The definitions seem to indicate a higher element of chance or randomness in gambling, while investing appears
to be more rational.

It could be argued that buying a stock based on a “hot tip” is essentially the same as placing money on a casino
which is considered as gambling. “Hot-tip” investors throw their money at any random investment, but “real”
investor not throws his money at any random investment.

For Example: Assume that there are playing card games, like poker, that demand skill. However, you cannot
choose the cards dealt out to you. In investing, you can choose your investment. This is the fundamental
difference between investing vs. gambling

In general; what does "real" investing mean? The essence of true investing is buying into companies behind the
stock and not just the stock itself. This means that you carefully research the fundamentals of the company, buy it
at a good price, and hold it for a meaningful period (typically a few years, unless the reasons you bought the stock
in the first place are not valid anymore).

"Buy and hold", a doctrine recommended by the majority of investors, means you buy something with the
intention of holding it as long as possible. The analysis is done on the basis that the business being bought is to be
held for quite some time, and there is more of a focus on valuation and the business operations of the company
than the price action in the market.

Buying stocks based on "hot tips", trading frequently by following the fluctuation of the market, and holding on
to certain stocks based on pure sentiment (emotion) is not investing. It's speculation.

INVESTMENT OBJECTIVES

i) INCOME: Investors who seek investments primarily focused on the continued receipt of current income,
while recognizing and accepting market and issuer risks inherent in investments of this type. Investors in the
category are usually seeking income above the market average, but carry higher risks and can be more volatile
than the general market.

ii) GROWTH: Investors who seek investments primarily focused on achieving high capital appreciation with
little emphasis on the generation of current income. Investors using this approach expect to have higher-than-
average increases in revenues and returns and accept a higher risk.

iii) SPECULATION: This investment approach seeks maximum gain and accepts maximum risks. Investors
who seek investments focused on speculation seek the highest gains without regard to holding period and
accept the potential of the entire loss of their principal in return for the potential gain.

iv) GROWTH & INCOME: For investors who seek both higher returns from capital appreciation and some
current income by investing the portfolio primarily in growth equities which produce little or no current

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income and in income producing investment of all grades, while recognizing and accepting the increased risks
associated with investment of this type. Investors accept some risk and greater volatility than the “income”
objective in this category.

Characteristic of Investment
The sophisticated nature of investing means that a lot goes into making an investment decision. Since there is
much at stake, an investor should consider the basic attributes of investments when deciding on a suitable option.

At least four investment attributes are integral to sound decisions in this sphere:

1) Safety 3) Liquidity

2) Rate of return 4) Duration

(1) Safety: - Although the degree of risk varies across investment types, all investments bear risk. Therefore, it is
important to determine how much risk is involved in a selected option. The average performance of an
investment normally provides a good indicator. However, past performance is merely a guide to future
performance – not a guarantee. Some instruments, like variable annuities, may have a safety net while others
expose the investor to comprehensive losses in the event of failure. Investors should also consider whether
they could manage the associated safety risk – financially and psychologically.
(2) Rate of return: - Investments generally provide higher rates of return compared to other asset classes, such as
cash and income options. The rate of return compensates for the level of risk involved. Therefore, higher risks
should necessarily bear higher rates of return to attract investors. It is important not to be preoccupied with
the rate of return without assessing its relation to safety.
(3) Liquidity: - This refers to how easily you can convert to cash or cash equivalents. In other words, a liquid
investment is tradable – there are sufficient buyers and sellers on the market when it is liquid. An example of
this is currency trading. When you trade currencies, there is always someone willing to buy when you want to
sell and vice versa. With other investments, like stock options, you may hold an illiquid asset at various points
in your horizon.
(4) Duration: - Investments typically have a longer horizon than cash and income options. Their duration,
particularly how long it may take to generate a healthy rate of return, is a vital consideration for an investor.
The investment horizon should match the period that your funds must be invested for or how long it would
take to generate a desired return.

A good investment has a good risk-return trade-off and provides a good return-duration trade-off as well. Given
that there are several risks that an investment faces, it is important to use these attributes to assess the suitability
of an option. A good investment is one that suits your investment objectives. To do that, it must have a
combination of attributes that satisfy you.

Investment Avenues

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There are a large number of investment instruments available today. To make our lives easier we would classify
or group them under 4 main types of investment avenues. We shall name and briefly describe them.

1) Financial securities: These investment instruments are freely tradable and negotiable. These would include
equity shares, preference shares, convertible debentures, non-convertible debentures, public sector bonds,
savings certificates, gilt-edged securities and money market securities.
2) Non-securitized financial securities: These investment instruments are not tradable, transferable nor
negotiable. And would include bank deposits, company fixed deposits, provident fund schemes, national
savings schemes and life insurance.
3) Mutual fund schemes: If an investor does not directly want to invest in the markets, he/she could buy
units/shares in a mutual fund scheme. These schemes are mainly growth (or equity) oriented, income (or debt)
oriented or balanced (i.e. both growth and debt) schemes.
4) Real assets: Real assets are physical investments, which would include real estate, gold & silver, precious
stones, rare coins & stamps and art objects.

Before choosing the avenue for investment the investor would probably want to evaluate and compare them. This
would also help him in creating a well diversified portfolio, which is both maintainable and manageable.

The investors have the following investment alternatives:

Indirect investing

Indirect investing is the buying and selling of the shares of investment companies which hold portfolios of
securities. Examples are: the assets of mutual funds which the most popular type of Investment Company.
Households also own a large, and growing, amount of pension fund reserves, and they are actively involved in the
allocation decisions of pension funds through plans and other self-directed retirement plans. Most of this amount
is being invested by pension funds, on behalf of households, in equity and fixed-income securities, the primary
securities of interest to most individual investors. Pension funds (both public and private) are the largest single
institutional owner of common stocks.

Direct Investing

The investment alternatives available through direct investing involves securities that investors not only buy and
sell themselves but also have direct control over. Investors, who invest directly in financial markets, either using a
broker or by other means, have a wide variety of assets from which to choose.

Non-marketable investment opportunities, such as savings accounts at saving institutions, are discussed briefly
since investors often own, or have owned these assets and are familiar with them. However, in this course we
concentrate on marketable securities. Marketable securities may be classified into one of three categories: the
money market, the capital market, and the derivatives market.

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Investors should understand money market securities, particularly Treasury bills, but they typically will not own
these securities directly, choosing instead of own them through the money market funds. Within the capital
market, securities can be classified as either fixed - income or equity securities. Finally, investors may choose to
use derivative securities in their portfolios. The market value of these securities is derived from an underlying
security such as common stock.

DIRECT INVESTING INDIRECT INVESTMENT

Markets Securities Investment Assets

companies
Non marketable _ Savings deposits Mutual Funds _ Money market mutual funds
_ Nonnegotiable certificates of deposit
_ Stock, bond, and income funds
_ Savings bonds
Money market  Treasury bills Pension Funds Pension Funds Assets
 Negotiable certificates of deposit
 Commercial paper
 Equity securities
 Repurchase agreements  Fixed-income securities
 Banker’s acceptances
Capital market Fixed income
 Government bonds
 Municipals bonds
 Corporate bonds
Equities (Stocks)
 Preferred stock
 Common stock
Derivatives  Options contracts
market  Future contracts

Financial Market

In economics, a financial market is a mechanism that allows people to buy and sell (trade) financial
securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods), and
other fungible items of value at low transaction costs and at prices that reflect the efficient-market hypothesis.

Both general markets (where many commodities are traded) and specialized markets (where only one commodity
is traded) exist. Markets work by placing many interested buyers and sellers in one "place", thus making it easier
for them to find each other.

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The term "market" is sometimes used for what are more strictly exchanges, organizations that facilitate the trade
in financial securities, e.g., a stock exchange, foreign exchange or commodity exchange. This may be a physical
location (like the NYSE) or an electronic system (like NASDAQ).

In finance, financial markets facilitate:

 The raising of capital (in the capital markets)
 The transfer of risk (in the derivatives markets)
 The transfer of liquidity (in the money markets)
 International trade (in the foreign exchange markets)
 And are used to match those who want capital to those who have it.

Types of Financial Markets

The financial markets can be divided into different sub-types:

 Capital markets which consist of:
 Stock markets, which provide financing through the issuance of shares or common stock, and
enable the subsequent trading thereof.
 Bond markets, which provide financing through the issuance of bonds, and enable the subsequent
trading thereof.
 Money markets, which provide short term debt financing and investment.

 Commodity markets, which facilitate the trading of commodities.

 Derivatives markets, which provide instruments for the management of financial risk.

 Futures markets, which provide standardized forward contracts for trading products at some future date.

 Insurance markets, which facilitate the redistribution of various risks.

 Foreign exchange markets, which facilitate the trading of foreign currencies.

 The capital markets consist of primary markets and secondary markets. Newly issued securities are
bought or sold in primary markets. Secondary markets allow investors to sell securities that they hold or
buy existing securities.
Functions of Financial Markets

Economic system relies heavily on financial resources and transactions, and economic efficiency rests in part on
efficient financial markets.

Financial markets consist of agents, brokers, institutions, and intermediaries transacting purchases and sales of
securities. The many persons and institutions operating in the financial markets are linked by contracts,
communications networks which form an externally visible financial structure, laws, and friendships. The
financial market is divided between investors and financial institutions.

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The term financial institution is a broad phrase referring to organizations which act as agents, brokers, and
intermediaries in financial transactions. Agents and brokers contract on behalf of others; intermediaries sell for
their own account. Financial intermediaries purchase securities for their own account and sell their own liabilities
and common stock. For example, a stockbroker buys and sells stocks for us as our agent, but a savings and loan
borrows our money (savings account) and lends it to others (mortgage loan). The stockbroker is classified as an
agent and broker, and savings and loan is called a financial intermediary. Brokers and savings and loans, like all
financial institutions, buy and sell securities, but they are classified separately, because the primary activity of
brokers is buying and selling rather than buying and holding an investment portfolio. Financial institutions are
classified according to their primary activity, although they frequently engage in overlapping activities.

Financial markets provide our specialized, interdependent economy with many financial services, including time
preference, distribution of risk, diversification of risk, transactions economy, transmutation of contractual
arrangements, and financial management.

Time Preference: - Time preference refers to the value of money spent now relative to money available for
spending in the future. Businesses are frequently making decisions among short-term and long-term uses of funds,
and business executives must judge between outlays which provide a return in the near term and those which pay
off many years from now. They must decide upon commitments requiring funds now and those requiring funds
later, by allocating not only funds that they expect to receive currently, but also those that they expect to receive
in the future.

The money and capital markets price funds so that businesses and governments can make rational economic
allocations of capital. The price of capital is set in a competitive marketplace by supply and demand forces. The
market price of capital is compared by businesses to the expected returns in proposed capital expenditures.
Businesses allocate their capital to real investments whose return is at above the cost of capital. Long-term
investments are compared to short-term investments using the financial-market-determined cost of capital.
Consequently, the allocation of capital between short-and long-term investments depends on the free play of
supply and demand in an open market.

Like businesspersons, consumers may decide upon a time pattern for expenditures that does not necessarily
coincide with their current or expected income flows. Financial markets allow us to implement time adjustments
in the payments for goods. Without them, there would be no opportunity to earn interest on savings, and
expenditures would be limited to current receipts and cash. Savings allows many consumers to postpone
consumption and to receive returns from investments.

Risk Distribution: - The financial markets distribute economic risks. Employment and investment risks are
separated by the creation and distribution of financial securities. On a larger scale, the money and capital markets
transfer the massive risks from people actually performing the work (employment risks) to savers who accept the
risk of an uncertain return. The chance of failure for a 100 million € mobile phones manufacturer may be divided
among thousands of investors living and working all over the world. If the mobile phones business fails, each

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investor loses only part of his or her wealth and may continue to receive income from other investments and
employment.

Diversification of risk: - In addition to permitting individuals to separate employment and investment risks, the
financial markets allow individuals to diversify among investments. Diversification means combining securities
with different attributes into a portfolio. Ordinarily, a diversified portfolio of financial claims is less risky than a
portfolio consisting of one or at most a handful of similar securities. Total risk is reduced because losses in some
investments are offset by gains in others. The benefits of diversification are possible due to the existence of large,
diversified financial markets where investors may buy and sell securities with minimum transactions cost,
regulatory interference, and so forth.

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